FRB:Speech, Bernanke--Monetary policy and the stock market--October 2, 2003

13/06/11 2:01 PM

Remarks by Governor Ben S. Bernanke

At the Fall 2003 Banking and Finance Lecture, Widener University, Chester,
Pennsylvania
October 2, 2003
Governor Bernanke presented identical remarks at the London School of Economics Public
Lecture, London, England, October 9, 2003

Monetary Policy and the Stock Market: Some Empirical Results

The ultimate objective of monetary policymakers is to promote the health of the U.S.
economy, which we do by pursuing our mandated goals of price stability and maximum
sustainable output and employment. However, the effects of our policy instruments, such as
the short-term interest rate, on these goal variables are indirect at best. Instead, monetary
policy actions have their most direct and immediate effects on the broader financial
markets, including the stock market, government and corporate bond markets, mortgage
markets, markets for consumer credit, foreign exchange markets, and many others. If all
goes as planned, the changes in financial asset prices and returns induced by the actions of
monetary policymakers lead to the changes in economic behavior that the policy was trying
to achieve. Thus, understanding how monetary policy affects the broader economy
necessarily entails understanding both how policy actions affect key financial markets, as
well as how changes in asset prices and returns in these markets in turn affect the behavior
of households, firms, and other decisionmakers. Studying these links is an ongoing
enterprise of monetary economists both within and outside the Federal Reserve System.
The link between monetary policy and the stock market is of particular interest. Stock
prices are among the most closely watched asset prices in the economy and are viewed as
being highly sensitive to economic conditions. Stock prices have also been known to swing
rather widely, leading to concerns about possible "bubbles" or other deviations of stock
prices from fundamental values that may have adverse implications for the economy. It is
of great interest, then, to understand more precisely how monetary policy and the stock
market are related.
In my talk today, I will report the results of research that I have done on this topic with
Kenneth Kuttner of the Federal Reserve Bank of New York, as well as the findings of
some related work done both within and outside the Federal Reserve System. 1 The views I
will express today, however, are my own and not necessarily those of my colleagues on the
Federal Open Market Committee (FOMC) or the Board of Governors of the Federal
Reserve System.
In our research, Kuttner and I asked two questions. First, by how much do changes in
monetary policy affect equity prices? As you will see, we focus on changes in monetary
policy that are unanticipated by market participants because anticipated changes in policy
should already be discounted by stock market investors and, hence, are unlikely to affect
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equity prices at the time they are announced. We find an effect of moderate size: Monetary
policy matters for the stock market but, on the other hand, it is not one of the major
influences on equity prices.
Our second question, both more interesting and more difficult, is, why do changes in
monetary policy affect stock prices? We come up with a rather surprising answer, at least
one that was surprising to us. We find that unanticipated changes in monetary policy affect
stock prices not so much by influencing expected dividends or the risk-free real interest
rate, but rather by affecting the perceived riskiness of stocks. A tightening of monetary
policy, for example, leads investors to view stocks as riskier investments and thus to
demand a higher return to hold stocks. For a given path of expected dividends, a higher
expected return can be achieved only by a fall in the current stock price. As we will see,
this finding has interesting implications for several issues, including the role of stock prices
in transmitting the effects of monetary policy actions to the broader economy and the
potential effectiveness of monetary policy in "pricking" putative bubbles in the stock
market. I will come back to these issues at the end of my talk. I start, however, with the
problem of measuring the effect of monetary policy on the stock market.
The Effect of Monetary Policy Actions on the Stock Market
Normally, the FOMC, the monetary policymaking arm of the Federal Reserve, announces
its interest rate decisions at around 2:15 p.m. following each of its eight regularly
scheduled meetings each year. An air of expectation reigns in financial markets in the few
minutes before to the announcement. If you happen to have access to a monitor that tracks
key market indexes, at 2:15 p.m. on an announcement day you can watch those indexes
quiver as if trying to digest the information in the rate decision and the FOMC's
accompanying statement of explanation. Then the black line representing each market
index moves quickly up or down, and the markets have priced the FOMC action into the
aggregate values of U.S. equities, bonds, and other assets.
On occasion, if economic conditions warrant, the FOMC may decide to make a change in
monetary policy on a day that falls between regularly scheduled meetings, a so-called
intermeeting move. Intermeeting moves, typically agreed upon during a conference call of
the Committee, nearly always take financial markets by surprise, at least in their precise
timing, and they are often followed by dramatic swings in asset prices.
Even the casual observer can have no doubt, then, that FOMC decisions move asset prices,
including equity prices. Estimating the size and duration of these effects, however, is not so
straightforward. Because traders in equity markets, as in most other financial markets, are
generally highly informed and sophisticated, any policy decision that is largely anticipated
will already be factored into stock prices and will elicit little reaction when announced. To
measure the effects of monetary policy changes on the stock market, then, we need to have
a measure of the portion of a given change in monetary policy that the market had not
already anticipated before the FOMC's formal announcement.
Fortunately, the financial markets themselves are a source of useful information about
monetary policy expectations. As you may know, the FOMC implements its decisions
about monetary policy by changing its target for a particular short-term interest rate, the
federal funds rate. The federal funds rate is the rate at which depository institutions borrow
and lend reserves to and from each other overnight; although the Federal Reserve does not
control the federal funds rate directly, it can do so indirectly by varying the supply of
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reserves available to be traded in this market. Since October 1988, financial investors have
been able to hedge and speculate on future values of the federal funds rate by trading
contracts in a futures market, overseen by the Chicago Board of Trade. Investors in this
market have a strong financial incentive to try to guess correctly what the federal funds rate
will be, on average, at various points in the future. The existence of a market in federal
funds futures is a boon not only to investors, such as banks, which want to protect
themselves against changes in the cost of reserves, but also to both policymakers and
researchers, because it allows any observer to infer from the sale prices of futures contracts
the values of the federal funds rate that market participants anticipate at various future
dates.2 Previous research (Krueger and Kuttner, 1996; Owens and Webb, 2001) has shown
that participants in this market collectively do a good job of forecasting future values of the
funds rate, efficiently incorporating available information about likely future monetary
policy actions. 3
By using data from the federal funds futures market, then, it is possible to estimate the
value at which financial market participants expect the FOMC to set its target for the
federal funds rate on any given date. By comparing this expected value to what the FOMC
actually did at each date, we can determine the portion of the Fed's interest rate decision
that came as a surprise to financial markets. In our research, Kuttner and I considered all
the dates of scheduled FOMC meetings plus all the dates on which the FOMC changed the
federal funds rate between meetings, or made intermeeting moves, for the period May 1989
through December 2002, amounting to a total of 131 observations.4 For each of these dates,
we used the expected value of the federal funds rate as inferred from the futures market to
divide the actual change in the federal funds rate on that day into the part that was
anticipated by the markets and the part that was unanticipated. 5 So, for example, on
November 6, 2002, the Federal Reserve cut the federal funds rate by 50 basis points. (A
basis point equals 1/100 of a percentage point, so a 50-basis-point cut equals a cut of 1/2
percentage point.) However, this cut in the federal funds rate was not entirely unexpected;
indeed, according to the federal funds futures market, investors were expecting a cut of
about 31 basis points, on average, from the Fed at that meeting.6 So, of the 50 basis points
that the FOMC lowered its target for the federal funds rate last November 6, only 19 basis
points were a surprise to financial markets and thus should have been expected to affect
asset prices. Note, by the way, that if the Fed had not changed interest rates at all that day,
our method would have treated that action as the equivalent of a surprise tightening of
policy of 31 basis points because the Fed would have done nothing while the market was
expecting an easing of 31 basis points.
To evaluate the effect of monetary policy on the stock market, we looked at how broad
measures of stock prices moved on days on which the Fed made unanticipated changes to
policy. I can illustrate our method by continuing the example of the Fed's cut in the federal
funds rate last November 6. On that day, the broad stock market index we used in our study
(the value-weighted index constructed by the Center for Research in Securities Prices at the
University of Chicago) rose in value by 0.96 percentage point. Dividing the 96-basis-point
gain in the stock market by the 19-basis-point downward surprise in the funds rate, we
obtain a value of approximately 5 for the "stock price multiplier" relating policy changes to
stock market changes. If this one day were representative, we would conclude that each
basis point of surprise monetary easing leads to about a 5-basis-point increase in the value
of stocks. Or, choosing magnitudes that might be more helpful to the intuition, we could
just as well say that a surprise cut of 25 basis points in the federal funds rate should lead
the stock market to rise, on the same day, about 1.25 percentage points--about 120 points
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on the Dow Jones index at its current value. In fact, applying a formal regression analysis
to the full sample from 1989 to 2002, we found a number fairly close to this one, namely, a
stock price multiplier for monetary policy of about 4.7. We also found, as expected, that
changes in monetary policy that were anticipated by the market had small and statistically
unimportant effects on stock prices, presumably because these changes had already been
priced into stocks.7
Although a stock price multiplier of about five for unanticipated changes in the federal
funds rate is certainly not negligible, we should appreciate that unexpected changes in
monetary policy account for a tiny portion of the overall variability of the stock market.
Unanticipated movements in the federal funds rate of 20 basis points or more are relatively
rare (we observed only thirteen examples in our fourteen-year sample). Yet the change of
one percent or so in the stock market induced by the typical 20-basis-point "surprise" in the
funds rate is swamped by the overall variability of stock prices. For example, over the past
five years, the broad stock market has moved one percent or more on about 40 percent of
all trading days. Thus, news about monetary policy contributes very little to the day-to-day
fluctuations in stock prices.
We explored our empirical results with some care. We noted, for example, that a few of the
monetary policy changes in our sample were followed by what seemed to be excessive or
otherwise unusual stock market responses. A number of these responses occurred rather
recently, during the Fed's series of rate cuts in 2001. The Fed's surprise intermeeting cuts of
50 basis points each on January 3 and April 18 of that year were both greeted euphorically
by the stock market, with one-day increases in stock values of 5.3 percent and 4.0 percent,
respectively. By contrast, the rate cut of 50 basis points on March 20, 2001, was received
less enthusiastically. Even though the cut was more or less what the futures market had
been anticipating, the financial press reported that many equity market participants were
"disappointed" that the rate cut hadn't been an even larger 75-basis-point action. In any
event, the market lost more than 2 percent that day.
To ensure that our results did not depend on a few unusual observations, or "outliers," we
re-ran our regression, omitting the days with the most extreme or unusual market moves.
This more conservative analysis led to a smaller estimate of the effect of policy actions on
the stock market, a stock price multiplier of about 2.6 rather than 4.7. However, the effect
remains quite sharp in statistical terms.8
We considered other variations as well. For example, we investigated whether the
magnitude of the effect on the stock market of a surprise policy tightening (that is, an
increase in interest rates) differs from that of a surprise easing of comparable size. It does
not. Yet another experiment consisted of asking whether an unanticipated policy change
has a larger effect if it is thought by the market to signal a longer-lasting change in policy.
We measured the perceived permanence of policy changes by observing the effects of
unanticipated policy changes on the expected federal funds rate three months in the future,
as measured by the futures market. The stock market multiplier associated with
unanticipated policy moves that are perceived to be more permanent is a bit higher, as
would be expected; its value is about 6.9
In short, the statistical evidence is strong for a stock price multiplier of monetary policy of
something between 3 and 6, the higher values corresponding to policy changes that
investors perceive to be relatively more permanent. That is, according to our findings, a
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surprise easing by the Fed of 25 basis points will typically lead broad stock indexes to rise
from between 3/4 percentage point and 1-1/2 percentage points. Incidentally, similar
results obtain for stock values of industry groups: We find almost all industry stock
portfolios respond significantly to changes in monetary policy, with telecommunications,
high-tech, and durables goods industry stocks being the most sensitive to monetary policy
news, and energy, utilities, and health care stocks being the least sensitive.10 These results
can be broadly explained by the tendency of each industry group to move with the broad
market, or (to use the language of the standard capital asset pricing theory), by their
industry "betas."
Why Does Monetary Policy Affect Stock Prices?
It is interesting, though perhaps not terribly surprising, to know that Federal Reserve policy
actions affect stock prices. An even more interesting question, though, is, why does this
effect occur? Answering this question will give us some insight into how monetary policy
affects the economy, as well as the role that the stock market should play in policy
decisions.
A share of stock is a claim on the current and future dividends (or other cash flows, such as
stock buybacks) to be paid by a company. Suppose, for just a moment, that financial
investors do not care about risk. Then only two types of news ought to affect current stock
values: news that affects investor forecasts of current or future (after-tax) dividends or
news that affects forecasts of current or future short-term interest rates. News that current
or future dividends (which I want to think of here as being measured in real, or inflationadjusted, terms) are likely to be higher than previously expected--say, because the
company is expecting to be more profitable--should raise the current stock price. News that
current or future short-term interest rates (also measured in real, or inflation-adjusted,
terms) are likely to be higher than previously expected should depress the stock price.
There are two essentially equivalent ways of understanding why expectations of higher
short-term real interest rates should lower stock prices. First, to value future dividends, an
investor must discount them back to the present; as higher interest rates make a given
future dividend less valuable in today's dollars, higher interest rates reduce the value of a
share of stock. Second, higher real interest rates make investments other than stocks, such
as bonds, more attractive, raising the required return on stocks and reducing what investors
are willing to pay for them. Under either interpretation, expectations of higher real interest
rates are bad news for stocks.
So, to reiterate, in a world in which investors do not care about risk, stock prices should
change only with news about current or future dividends or about current or future real
interest rates. However, investors do care about risk, of course. Because investors care
about risk, and because stocks are viewed as relatively risky investments, investors
generally demand a higher average return, relative to other assets perceived to be safer, to
hold stocks. Using long historical averages, one finds that, in the United States, a
diversified portfolio of stocks has paid 5 to 6 percentage points more per year, on average,
than has a portfolio of government bonds. This extra return, known as the risk premium on
stocks, or the equity premium, presumably reflects, in part, the extra compensation that
investors demand to be willing to hold relatively more risky stocks. 11
Like news about dividends and real interest rates, news that affects the risk premium on
stocks also affects stock prices. For example, news of an impending recession could raise
the risk premium on stocks in two ways. First, the macroeconomic environment is more
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volatile than usual during a recession, so stocks themselves may become riskier
investments. Second, the incomes and wealth of financial investors tend to fall during a
downturn, giving them a smaller cushion to support the lifestyles to which they are
accustomed (that is, to make house payments and meet other obligations). With less
discretionary income and wealth to absorb potential losses, people may become less willing
to bear the risks of more volatile financial investments (Campbell and Cochrane, 1999).
For both reasons, the extra return that investors demand to hold stocks is likely to rise when
bad times loom. With expected dividends and the real interest rate on alternative assets held
constant, the expected yield on stocks can rise only through a decline in the current stock
price.12
We now have a list of three key factors that should affect stock prices. First, news that
current or future dividends will be higher should raise stock prices. Second, news that
current or future real short-term interest rates will be higher should lower stock prices. And
third, news that leads investors to demand a higher risk premium on stocks should lower
stock prices.
How does all this relate to the effects of monetary policy on stock prices? According to our
analysis, Fed actions should affect stock prices only to the extent that they affect investor
expectations about dividends, short-term real interest rates, or the riskiness of stocks. The
trick is to determine quantitatively which of these sets of investor expectations is likely to
be most affected when the Fed unexpectedly changes the federal funds rate.
To make this determination, we used a methodology first applied by the financial
economist John Campbell, of Harvard University, and by Campbell and John Ammer of
the Federal Reserve Board staff (Campbell, 1991; Campbell and Ammer, 1993). Putting
the details aside, we can describe the basic idea as follows. Imagine that the expectations of
stock market investors can be mimicked by a statistical forecasting model that takes
relevant current data as inputs and projects estimated future values of aggregate dividends,
real interest rates, and equity risk premiums as outputs. In principle, investors could use
such a model to make forecasts of these key variables and hence to estimate what they are
willing to pay for stocks. Besides a number of standard variables that have been shown to
be helpful in making forecasts of such financial variables, suppose we include in the
forecasting model our measure of unanticipated changes in the federal funds rate.13 That is,
we use the information contained in these unanticipated changes in making our forecasts of
future dividends, interest rates, and risk premiums.
Now we can consider the following thought experiment. Suppose we have run our
computer model, made our forecasts, and inferred the appropriate values for stocks. But
then we receive news that the Fed has unexpectedly raised the federal funds rate by 25
basis points. Based on our forecasting model, by how much would that information change
our previous forecasts of future dividends, interest rates, and risk premiums? The answer to
this question clarifies the channel by which monetary policy affects stock prices. If we
were to find, for example, that the news of an unexpected increase in the funds rate
significantly changed the forecast of future dividends but did not much affect the forecasts
of interest rates or risk premiums, then we could conclude that monetary policy affects
stock prices primarily by affecting investor expectations of future dividends. By contrast, if
news of the policy action changed the model forecasts for real interest rates but did not
change our forecasts for the other two variables, we would decide that unanticipated policy
actions affect stock prices primarily by influencing the interest rates expected by stock
investors.
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What we actually found when conducting this statistical experiment was quite interesting. It
appears that, for example, an unanticipated tightening of monetary policy leads to only a
modest change in forecasts of future dividends and to still less of a change in forecasts of
future real interest rates (beyond a few quarters). Quantitatively, according to our
methodology, the most important effect of a policy tightening is on the forecasted risk
premium. Specifically, an unanticipated tightening of monetary policy raises expected risk
premiums on stocks for a protracted period. For a given expected stream of dividend
payouts and real interest rates, the risk premium and hence the return to holding stocks can
only rise if the current stock price falls.
In short, our analysis suggests that an unanticipated monetary tightening lowers stock
prices only to a small extent by lowering investor expectations about future dividend
payouts, and by still less by raising expected real interest rates. The most powerful effect of
an unanticipated monetary tightening is to increase the perceived risk premium on stocks,
either by increasing the riskiness of stocks, by reducing people's willingness to bear risk, or
both. Reduced willingness of investors to hold relatively more risky stocks drives down
stock prices.
Our analysis does not explain precisely how monetary policy affects risk, but we can make
reasonable conjectures. For example, tighter monetary policy may raise the riskiness of
shares themselves by raising the interest costs and weakening the balance sheets of publicly
owned firms (Bernanke and Gertler, 1995). In the macroeconomy more generally, by
reducing spending and economic activity, tighter money raises the risks of unemployment
or bankruptcy faced by individual households or firms. In each case, tighter monetary
policy increases risk by reducing financial buffers or otherwise increasing the vulnerability
of individuals or firms to future shocks to the economy.
Implications of the Results for Monetary Policy
So far I have discussed two principal conclusions from the empirical analysis: First, the
stock price multiplier of monetary policy is between 3 and 6--in other words, an
unexpected change in the federal funds rate of 25 basis points leads, on average, to a
movement of stock prices in the opposite direction of between 3/4 percentage point and 11/2 percentage points. Second, the main reason that unanticipated changes in monetary
policy affect stock prices is that they affect the risk premium on stocks. In particular, a
surprise tightening of policy raises the risk premium, lowering current stock prices, and a
surprise easing lowers the risk premium, raising current stock prices.
What implications do these results have for our broader understanding and for the practice
of monetary policy? I will briefly discuss two issues: first, the role of the stock market in
the transmission of monetary policy changes to the economy; and second, the efficacy of
monetary policy as a tool for controlling stock market "bubbles."
A long-held element of the conventional wisdom is that the stock market is an important
part of the transmission mechanism for monetary policy. The logic goes as follows: Easier
monetary policy, for example, raises stock prices. Higher stock prices increase the wealth
of households, prompting consumers to spend more--a result known as the wealth effect.
Moreover, high stock prices effectively reduce the cost of capital for firms, stimulating
increased capital investment. Increases in both types of spending--consumer spending and
business spending--tend to stimulate the economy.
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This simple story can be elaborated somewhat in light of our results. It is true, as I have
discussed, that an easier monetary policy raises stock prices, whereas a tighter policy
lowers them. However, easier monetary policy not only raises stock prices; as we have
seen, it also lowers risk premiums, presumably reflecting both a reduction in economic and
financial volatility and an increase in the capacity of financial investors to bear risk. Thus,
our results suggest that easier monetary policy not only allows consumers to enjoy a capital
gain in their stock portfolios today, but it also reduces the effective amount of economic
and financial risk they must face. This reduction in risk may cause consumers to trim their
precautionary saving, that is, to reduce the amount of income that they put aside to protect
themselves against unforeseen contingencies. Reduced precautionary saving in turn implies
more spending by households. Thus, the reduction in risk associated with an easing of
monetary policy and the resulting reduction in precautionary saving may amplify the shortrun impact of policy operating through the traditional channel based on increased asset
values. Likewise, reduced risk and volatility may provide an extra kick to capital
expenditure in the short run, as firms are more likely to undertake investments in new
structures or equipment in a more stable macroeconomic environment.14
A second issue concerns the role of monetary policy in the management of large swings in
stock values, or "bubbles." In an earlier speech (Bernanke, 2002), I gave a number of
reasons why I believe that using monetary policy--as opposed to microeconomic,
prudential policies--is not a good way to address the problem of asset-market bubbles.
These included the difficulty of identifying bubbles in advance; the questionable wisdom,
in the context of a free-market economy, of setting up the central bank as the arbiter of
asset values; the problem that arises when a bubble occurs in only one asset class rather
than in all asset classes; and other reasons. A major concern that I have about the bubblepopping strategy, however, is that attempts to bring down stock prices by a significant
amount using monetary policy are likely to have highly deleterious and unwanted side
effects on the broader economy. The research I have described today allows me to address
this issue more concretely. Here I will make just two points.
First, this research suggests that relatively small changes in monetary policy would not do
much to curb a major overvaluation in the stock market. As we have seen, a surprise
tightening of 25 basis points should be expected to lower stock prices by only a little more
than 1 percent, which, as already noted, is a trivial movement relative to the overall
variability of the stock market. It would not be appropriate to extrapolate these results to try
to estimate how much tightening would be needed to correct a substantial putative
overvaluation in stock prices, but it seems clear that a light tapping of the brakes will not
be sufficient. What we can say is that the necessary policy move would have to be quite
large--many percentage points on the federal funds rate--and we would be highly uncertain
about its magnitude or its ultimate effects on stock prices and the economy.15,16
Second, we have seen that monetary tightening reduces stock prices primarily by increasing
the risk premium for holding stocks, as opposed to raising the real interest rate or lowering
expected dividends. The risk premium for stocks will rise only to the extent that broad
macroeconomic risk rises, or that people experience declines in income and wealth that
reduce their ability or willingness to absorb risk (Campbell and Cochrane, 1999). This
evidence supports the proposition that monetary policy can lower stock values only to the
extent that it weakens the broader economy, and in particular that it makes households
considerably worse off. Indeed, according to our analysis, policy would have to weaken the
general economy quite significantly to obtain a large decline in stock prices.
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Conclusion
I have reported today on empirical work, by my coauthor and me as well as by others,
about the links between monetary policy and the stock market. I have only touched on a
large literature, and I apologize to the many researchers whose work I have not been able
to describe today. But I hope that I have given you a flavor of how empirical research can
help us to refine our understanding of how monetary policy works and how policy should
be conducted.
REFERENCES
Bernanke, Ben (2002). "Asset-Price 'Bubbles' and Monetary Policy." Speech before the
New York chapter of the National Association for Business Economics, New York, New
York, October 15.
Bernanke, Ben and Mark Gertler (1995). "Inside the Black Box: The Credit Channel of
Monetary Transmission," Journal of Economic Perspectives, 9 (Fall), pp. 27-48.
Bernanke, Ben and Mark Gertler (2001). "Should Central Banks Respond to Movements in
Asset Prices?", American Economic Review, 91 (May), pp. 253-57.
Bernanke, Ben and Kenneth Kuttner (2003). "What Explains the Stock Market's Reaction
to Federal Reserve Policy?" Working paper, Federal Reserve Bank of New York, October.
Campbell, John (1991). "A Variance Decomposition for Stock Returns," Economic
Journal, 101 (March), pp. 157-79.
Campbell, John, and John Ammer (1993). "What Moves the Stock and Bond Markets? A
Variance Decomposition for Long-Term Asset Returns," Journal of Finance, 48 (March),
pp. 3-37.
Campbell, John, and John Cochrane (1999). "By Force of Habit: A Consumption-Based
Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, 107
(April), pp. 205-51.
D'Amico, Stefania, and Mira Farka (2002). "The Fed and the Stock Market: A Proxy and
Instrumental Variable Identification." Working paper, Columbia University.
Greenspan, Alan (2002). "Economic Volatility." Speech before a symposium sponsored by
the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30.
Guo, Hui (2002). "Stock Prices, Firm Size, and Changes in the Federal Funds Rate Target."
Working paper, Federal Reserve Bank of St. Louis, January.
Grkaynak, Refet, Brian Sack, and Eric Swanson (2002). "Market-Based Measures of
Monetary Policy Expectations." Working paper, Board of Governors of the Federal
Reserve System, June.
Krueger, Joel, and Kenneth Kuttner (1996). "The Fed Funds Futures Rate as a Predictor of
Federal Reserve Policy," Journal of Futures Markets, 16 (December), pp. 865-79.
Kuttner, Kenneth (2001). "Monetary Policy Surprises and Interest Rates: Evidence from the
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Fed Funds Futures Market," Journal of Monetary Economics, 47 (June), pp. 523-44.
Lettau, Martin, and Sydney Ludvigson (2001). "Consumption, Aggregate Wealth, and
Expected Stock Returns," Journal of Finance, 56 (June), pp. 815-49.
Lettau, Martin, and Sydney Ludvigson (2002). "Time-Varying Risk Premiums and the Cost
of Capital: An Alternative Interpretation of the Q Theory of Investment," Journal of
Monetary Economics, 49 (January), pp. 31-66.
Ludvigson, Sydney, Charles Steindel, and Martin Lettau (2002). "Monetary Policy
Transmission through the Consumption-Wealth Channel," Federal Reserve Bank of New
York, Economic Policy Review, 8 (May), pp. 117-133.
Owens, Raymond and Roy Webb (2001). "Using the Federal Funds Futures Market to
Predict Monetary Policy Actions," Federal Reserve Bank of Richmond, Economic
Quarterly, 87 (Spring), pp. 69-77.
Poole, William, Robert Rasche, and Daniel Thornton (2002). "Market Anticipations of
Monetary Policy Actions," Federal Reserve Bank of St. Louis, Review, 84 (July/August),
pp. 65-93.
Rigobon, Roberto, and Brian Sack (2002). "The Impact of Monetary Policy on Asset
Prices," Finance and Economics Discussion Series 2002-4, Board of Governors of the
Federal Reserve System, January.
Sack, Brian (2002). "Extracting the Expected Path of Monetary Policy from Futures
Rates," Finance and Economics Discussion Series 2002-56, Board of Governors of the
Federal Reserve System, December.
Footnotes
1. Bernanke and Kuttner (2003);
http://www.ny.frb.org/research/staff_reports/sr174.html.Return to text
2. The futures contract is based on monthly averages of the federal funds rate, so that some
manipulation is needed to obtain the daily expectations of the funds rate used in this paper.
See Bernanke and Kuttner (2003) or Kuttner (2001) for further details. Allowing for risk
premiums creates another complication; see Sack (2002). I ignore these technicalities
here.Return to text
3. Other financial instruments, such as eurodollar futures rates, can and have been used to
forecast changes in the federal funds rate. Although each of the various alternatives has
advantages, Grkaynak, Sack, and Swanson (2002) find that the federal funds futures rate
is the best predictor of monetary policy actions for horizons out to several months. Return
to text
4. The beginning of the sample corresponds to the availability of the futures data. We
excluded the observation corresponding to September 17, 2001, the first day of trading
following the September 11 terrorist attacks. Return to text
5. That the Federal Reserve has only been formally announcing its policy moves since 1994
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added a measure of complexity to our research. Before then, market participants generally
did not become aware of the FOMC's policy decisions until those decisions were actually
implemented in the market for bank reserves, often the day after the FOMC decision. To
the extent possible, we dated the policy change as of the day that the market would have
become aware of it, not the day of the decision itself. See the paper for details. Return to
text
6. Investors would not literally expect the Fed to cut the funds rate by 31 basis points, since
the Fed usually moves in 25-basis-point increments. An average expectation of a 31-basispoint cut would be consistent with, for example, 62 percent of investors expecting a 50basis-point and 38 percent expecting no cut. Return to text
7. In principle, news other than the policy decision might affect the federal funds futures
contract during the day, so that the measure of unanticipated policy changes we use here
might be a "noisy" one. If so, our approach would underestimate the effect of policy
changes on the stock market. However, Poole, Rasche and Thornton (2002, pp. 68-69)
perform an analysis that suggests that the mismeasurement may be small in practice.
Further confirmation is provided by D'Amico and Farka (2002), who find results similar to
ours using ten-minute windows around the announcement; the benefit of a tight window is
that the policy announcement is highly likely to dominate movements in the contract over
that period. Return to text
8. Technically, we removed outlier observations based on their so-called influence
statistics, which measure the importance of individual observations to the overall results.
Another correction was needed because, in the early part of the sample, particularly
between 1989 and 1992, it was not uncommon for intermeeting rate cuts to take place on
the same day that the government issued weaker-than-expected reports about employment
growth. In such cases, our method cannot distinguish cleanly between the effects of the
employment news and the effects of the rate cut itself on the stock market. If we eliminate
both the outlier observations and the observations in which employment reports coincided
with rate changes, we find the multiplier effect of policy changes on the stock market to be
about 3.6 and again statistically significant. Return to text
9. To focus on policy surprises of longer duration, Rigobon and Sack (2002) derive their
measure of the unexpected policy change on the three-month eurodollar deposit rate, rather
than the current month's federal funds rate, as in this paper and in Kuttner (2001). Using a
methodology that also attempts to correct for two-way causality between the funds rate and
asset prices, and data for post-1993 scheduled FOMC meetings and Chairman's testimony
dates only, they find comparable though slightly higher values for the effect of monetary
policy on the stock market. For example, they find a policy multiplier for the Standard and
Poor's 500 index of 7.7. However, when they use data on the federal funds rate futures
market to measure policy shocks, Rigobon and Sack find results similar to ours, using their
sample and methodology. Return to text
10. Using methods similar to ours, Guo (2002) found that the impact of monetary policy
actions on stock prices does not seem to depend on firm size. Return to text
11. The existence of a large equity premium in the past is, of course, no guarantee of an
equally large equity premium in the future. The fact that equities are more widely held
today than in the past, implying that the risk of equities is more widely shared, is one
reason that the equity premium may be lower in the future than it has been in the past.
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Return to text
12. Of course, a looming recession is likely also to lower expected dividends (bad for
stocks) and lower interest rates (good for stocks). Generally, stock prices are a leading
indicator, falling ahead of recessions and rising in advance of recoveries (although with
many false signals). Return to text
13. Variables used in our forecasting model, besides the excess return on stocks, the onemonth real interest rate, and the unanticipated change in the funds rate, include the relative
bill rate (defined as the three-month Treasury bill rate minus its 12-month moving
average), the change in the bill rate, the smoothed dividend-price ratio, and the spread
between 10-year and one-month Treasury yields. Return to text
14. There is a bit more to this analysis. An additional complexity arises from the fact that,
although easier monetary policy allows consumers to enjoy a capital gain in their stock
portfolios today, it also "takes back" some of that gain, so to speak, by affording
shareholders a lower rate of return on their holdings, on average, in subsequent periods.
Research by Sydney Ludvigson and Martin Lettau of New York University and Charles
Steindel of the Federal Reserve Bank of New York (Ludvigson, Steindel, and Lettau, 2002;
Lettau and Ludvigson, 2001) suggests that, because the gain in share prices induced by a
monetary easing is partly transitory, consumers will not increase their spending in response
to stock price changes induced by monetary policy as much as they will in response to
stock price changes induced by other factors. The estimates in our paper suggest that this
differential effect will be relatively small, however. Also, to the extent that the capital
gains induced by monetary policy are perceived as partly transitory, the short-run response
of investment spending will be strengthened, as firms prefer to invest while stock prices
remain high; see Lettau and Ludvigson, 2002, for evidence. In short, if changes in stock
values induced by monetary policy are perceived as relatively more transitory, the effects
of policy will be concentrated more on investment spending and less on consumption
spending than the conventional wisdom suggests. Return to text
15. Greenspan (2002) notes several episodes in which increases in the federal funds rate of
several hundred basis points did not materially slow stock appreciation. He argues that
"such data suggest that nothing short of a sharp increase in short-term rates that engenders
a significant economic retrenchment is sufficient to check a nascent bubble." The late
Fischer Black once defined an efficient stock market as one in which prices are between
half and double fundamental values; if Black's view is to be believed, then identifiable
deviations of prices from fundamentals would have to be quite large indeed. Return to text
16. Implicitly I am considering here the case of a central bank that responds only
sporadically to stock prices, in those situations in which it perceives a bubble to be
forming. Irregular deviations from a policy rule focused on output and inflation seem
appropriately modeled as unanticipated movements in policy. An alternative policy strategy
would be to incorporate regular reactions to stock values into the systematic part of the
monetary policy reaction function. That strategy has some advantages, but it has the
important disadvantage that it does not discriminate between fundamental and
nonfundamental sources of changes in stock values. Bernanke and Gertler (2001) present
simulations showing that such a strategy is unlikely to be beneficial in terms of overall
macroeconomic stability. Return to text
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